Introduction

The Solvency II Directive (“S2”) is a new legislative regime for EU insurers, which is scheduled to commence on 1 January 2016.

S2 will entail a new system of supervision for assessing the overall financial position of an insurance undertaking. S2 will have implications for investment management of the assets of insurance companies, arising from the S2 capital requirements, and also from specific rules relating to investment management practices.

The Three Pillars 

S2 is based on three pillars. The new rules which are derived from each pillar will affect how an insurance undertaking’s assets can be invested.

Pillar I  - Quantitative - Capital Requirements

Pillar I prescribes minimum capital requirements for insurance companies. These are the Solvency Capital Requirement (“SCR”) and the Minimum Capital Requirement (“MCR”). SCR is a risk-based requirement. Insurance undertakings will be permitted to use the European Standard Formula or the undertaking’s own internal model, when calculating SCR. SCR will cover the quantifiable risks of an insurer. MCR is the minimum level of capital required. A breach of MCR could result in withdrawal of an insurance undertaking’s regulatory authorisation.

An insurance undertaking may be required to change the composition of its overall portfolio of investments, in order to meet SCR and MCR.

Pillar II – Qualitative - Supervisory

Pillar II outlines the qualitative requirements for insurance companies, and addresses matters such as risk management and corporate governance. Pillar II entails a higher standard of risk management and control, which will most likely require a greater degree of interaction between insurance companies and any of their third party investment managers. 

Insurance undertakings and their investment managers will need to review and potentially amend the terms of the relevant investment management agreement, in order to ensure compliance with S2.

Pillar III – Reporting and Disclosure

Pillar III will require insurance undertakings to disclose certain information to the public and to regulators. These are significantly more onerous than current reporting and disclosure rules. In order for the insurance undertaking to adhere to these obligations, it will be necessary for the undertaking to receive more detailed and more frequent reports from third party investment managers, in relation to assets under management.

Specific Rules on Investment Management

Insurance undertakings that are authorised by the Central Bank of Ireland are required to comply with the Central Bank’s Guidelines for Insurance Undertakings on Asset Management (the “Guidelines”). The Guidelines contain rules on how insurance undertakings must invest in and hold assets to adequately cover both their technical provisions and their required solvency margin; in order to ensure that the undertaking can meet its contractual liabilities to policy holders. S2 also contains rules that address such matters. These rules are summarised below.

Prudent Person Principle

Insurance undertakings will be required to invest all their assets in accordance with the ‘prudent person principle’ as specified in S2. The prudent person principle provides:

  • With respect to the whole portfolio of assets, insurance undertakings shall only invest in assets and instruments whose risks the undertaking concerned can properly identify, measure, monitor, manage, control and report, and appropriately take into account in the assessment of its overall solvency needs. 
  • All assets, in particular covering the MCR and SCR, shall be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.  In addition, the localisation of those assets shall be such as to ensure their availability.
  • Assets held to cover the technical provisions shall also be invested in a manner appropriate to the nature and duration of the insurance liabilities. Those assets shall be invested in the best interest of all policy holders and beneficiaries taking into account any disclosed policy objective. 
  • In the case of a conflict of interest, insurance undertakings, or the entity which manages their asset portfolio, shall ensure that the investment is made in the best interest of policy holders and beneficiaries.
  • With respect to assets held in respect of life insurance contracts where the investment risk is borne by the policy holders, the following rules shall apply:
    • Where the benefits provided by a contract are directly linked to the value of units in a UCITS, or to the value of assets contained in an internal fund held by the insurance undertaking, usually divided into units, the technical provisions in respect of those benefits must be represented as closely as possible by those units, or in the case where units are not established, by those assets.
    • Where the benefits provided by a contract are directly linked to a share index or some other reference value, the technical provisions in respect of those benefits must be represented as closely as possible either by the units deemed to represent the reference value or, in the case where units are not established, by assets of appropriate security and marketability which correspond as closely as possible with those on which the particular reference value is based. 
    • Where the benefits referred to above include a guarantee of investment performance or some other guaranteed benefit, the assets held to cover the corresponding additional technical provisions shall be subject to the following rules: 
      • The use of derivative instruments shall be possible insofar as they contribute to a reduction of risks or facilitate efficient portfolio management.
      • Investment and assets which are not admitted to trading on a regulated financial market shall be kept to prudent levels. 
      • Assets shall be properly diversified in such a way as to avoid excessive reliance in any particular asset, issuer or group of undertakings, or geographical area and excessive accumulation of risk in the portfolio as a whole.
      • Investment in assets issued by the same issuer, or by issuers belonging to the same group shall not expose the insurance undertaking to excessive risk concentration. 

Insurance undertakings will be required to comply with the above rules on investment management, in addition to the Guidelines. The Guidelines may be amended or replaced when S2 is implemented in Ireland.

Implementation

It must be noted that S2 imposes the following restrictions on Member States when transposing S2 into national law:

  • Member States shall not require insurance undertakings to invest in particular categories of asset.
  • Member states shall not subject the investment decisions of an insurance undertaking or its investment manager to any kind of prior approval or systemic notification requirements. 
  • With respect to insurance risks situated in EU, Member States shall not require that the assets held to cover the technical provisions related to those risks are localised in the EU.

S2 must be implemented in Member States by 1 January 2016. Meanwhile, insurance undertakings and their investment managers could consider how they can prepare for the forthcoming new rules which are outlined above.